Money Talks

Much of the hand-wringing over American innovation can be traced to some troubling trends in the financing of research and development. Innovation has always been a crucial driver of the country's economic engine, and as such it has always been well looked after. No other nation spends more on R&D than the U.S., which contributes 44 percent to the worldwide total. But budget deficits, a costly war in Iraq and an ongoing economic slump are all contributing to a widespread pullback.

When it comes to funding innovation today, the lion's share of the money comes from corporate R&D spending. More than 68 percent of all domestic R&D is funded by the private sector, a dramatic shift from 20 years ago, when the federal government financed the majority of it. The danger in that shifting tide is that corporate R&D spending is closely pegged to business cycles. When money is tight, as it is now, R&D budgets get slashed early and often. Over the past four years, private industry in the U.S. has issued a collective shrug when it comes to filling the R&D coffers. Even the technology companies whose lifeblood is innovation have been reducing their spending on R&D as a percentage of sales, and refocusing the money on product development, rather than basic research that may not yield marketable products. The NSF estimates that between 2000 and 2003, nonfederal funding of R&D from private industry declined 2.3 percent.

"The drumbeat pressures of quarterly results are . . . drowning out long-term management, investment and innovation strategies," write the authors of the "National Innovation Initiative," the report issued by the Council on Competitiveness. But they'll find no sympathy from the likes of Wall Street. "Who wants to invest in core R&D with no visible upside?" asks Pip Coburn, global technology strategist at UBS Warburg. He says it isn't Wall Street's job to reward companies for basic research; it's to reward them for innovation that leads to revenues.

At least part of the problem is the major spending pullback that followed the Internet bust of 2001, and there's no reason to think that R&D spending won't eventually rebound. But the numbers are down across the board. Federal funding of nondefense-related R&D increased only 1.4 percent between 2004 and 2005, while defense R&D climbed 6.2 percent, to an all-time high of $74 billion. And though it is true that many market-changing innovations, such as the Internet itself, have come from defense research in the past, almost all of the increase in defense spending is dedicated to new weapons systems.

While the federal funding of research in the physical sciences as a percentage of GDP has declined steadily in the U.S. over the past 30 years, China doubled its spending on R&D in just the last ten yearsfrom 0.6 percent to 1.2 percent of GDP, which is currently about $1.2 trillionand plans to boost its proportion of science spending on basic research more than 200 percent in the next ten years.

Friedman may be right that where innovation happens matters. But it is also true that where the consumer markets are also matters. And at the moment, everyone is closely watching the rapidly maturing Chinese market. More and more R&D is being sent overseas in an attempt to leverage cheap labor and address those local markets. The Economist Intelligence Unit, the research arm of The Economist magazine, published a survey in September 2004 showing that global executives plan to make more R&D investments in China than anyplace else over the next three years. The U.S. finished a distant second, followed closely by India.

Meanwhile, overseas multinational companies are happily stepping in to fill the widening void in R&D funding in the U.S. When American universities don't get enough financing from the federal government or U.S.-based companies, lines of foreign firms await with checkbooks at the ready. Arup Gupta, president of Tata Consultancy Services America, a subsidiary of Mumbai, India-based Tata Group, says that investing in American universities is part of TCS's strategy to leverage the innovation infrastructure in the U.S. In addition to investing in research centers in India, TCS spends heavilyas much as $3.5 million a yearsponsoring chairs and research centers at such schools as the Massachusetts Institute of Technology, Carnegie Mellon University and the Georgia Institute of Technology, and walks away with whatever intellectual property is created. "Today, we are not seeing enough innovation from the Indian companies," Gupta says. "But we understand that cost reduction is just a one-time benefit, and innovation is crucial to our long-term survival. We are trying to emulate the U.S. model."